Looking for healthier returns

With the healthcare sector having come to the world’s rescue at the behest of governments during the pandemic, one would be forgiven for thinking that it should now be a stock market darling – the industry’s response has certainly improved its image. Yet, despite having outperformed in recent years, the MSCI World Healthcare index is at another low relative to the MSCI All Country World index. Various factors account for this including a rotation in market leadership and regulatory concerns. However, while stock and subsector selection will as usual remain of key importance, various catalysts offer the prospect of a re-rating.

Sentiment and fundamentals

The Oxford AstraZeneca vaccine helped more people than any other, is the most widely accepted with around 120 governments recognising it, is approved by the World Health Organisation, and was priced at cost. And yet, over the last year, when the FTSE All-Share has risen over 20%, the company’s share price has lagged far behind. Such performance reflects the malaise generally regarding the sector’s stock market plight – the index is trading at around a 15% discount to broader equity indices.

Part of the problem is the threat of more restrictive regulation. President Biden’s team is questioning why the rest of the world on average pays almost half what the US does for its drugs. There are various nuances to the situation. However, the Democrat’s narrow majority in Congress, together with close examination of the administration’s proposed policies, suggest any legislation will be much diluted by the time it is enacted – assuming it gets that far. Narrow majorities tend not to result in controversial legislation. The political headwind will gradually recede.

In assessing sector prospects, it is important to recognise the long-term investment case remains intact. This includes ageing populations, the significant urbanisation and change in diet in the developing countries, and recognition by governments that more needs to be spent on health. The pandemic has highlighted the need for governments to provide efficient healthcare systems, together with the associated infrastructure – this is particularly true in some developing countries, where widespread shortages and rioting are causing a rethink by those in charge. The tailwind is still in place.

It is the shorter term considerations which, in aggregate, are likely to spur a sector re-rating. The recent modest rotation in stock market leadership followed news of the vaccine efficacy rates last year which encouraged investors to believe the pandemic would end sooner than expected. Many stocks that had otherwise been laggards were suddenly in demand, and therefore outperformed the healthcare sector and market. In reality, once the euphoria subsides, market leadership is likely to be more broadly based. Such circumstances should be more favourable to those sectors offering a superior earnings outlook.

A further potential catalyst for a re-rating is likely to be a growing realisation of the unprecedented level and speed of innovation across the industry, which some respected investors are describing as an innovation revolution. As its sheer scale and reach becomes more evident, the market will come to question why a sector with better prospects than most is on a discount to the market. The sector spans many subsectors and tends to be defensive as it is resilient to economic downturns, but it is also home to many emerging and fast-growing subsectors including robotic surgery, diagnostics and radiotherapy.

Gene sequencing is enabling treatments to be developed more quickly. Advances in genomics and biotechnology mean that the number of disease states and treatable targets is at an all-time high, and this is being particularly helped by novel platform technologies which have enabled even more therapies to target diseases previously thought to be untreatable.

New diagnostic tools are helping to identify and treat diseases more easily and cheaply. AI and Big Data can now more than compete with the average medical profession when it comes to accurately diagnosing numerous diseases. There are exciting developments in cancer treatments which harness the body’s natural immune system to attack tumours – and, as it is far less intrusive and has fewer side-effects than radiation or chemotherapy, treatment costs are much reduced particularly as better technology is making for earlier diagnosis.

Opportunities abound across a range of these subsectors. But stock selection and maintaining the right balance between subsectors will be crucial. For example, the portfolios had profited by being early supporters of biotechnology. Yet, while the outlook for this subsector remains encouraging, exposure has been reduced in favour of more ‘general’ specialist trusts which enjoy greater latitude in capitalising on the ever-increasing number of subsectors which offer equally exciting prospects, if not more.

Likewise, questions are being asked of the less innovative and larger pharmaceutical companies. No company has a monopoly on gene sequencing, and so more competition for drugs is likely to reduce profit margins. In such cases, strong cash flow from existing operations may support an attractive dividend policy but this can only delay the inevitable unless a healthy drug pipeline is developed – or bought. Indeed, continued M&A activity may further help to act as a catalyst for a re-rating.

There is a further short-term consideration. The wider market’s belief in a strong economic recovery is being reflected in those healthcare subsectors most impacted by the pandemic – these include hospitals, dental care, care providers and therapies. The prospect of a strong rebound continues to look encouraging, and may encourage investors to look more favourably upon the sector generally.

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